The Bipartisan Budget Act of 2015 has not only prevented a government shutdown and lifted the debt limit, it has increased both defense and domestic spending above the so-called "sequestration" spending caps. With this, it has resolved the President's main opposition to the National Defense Authorization Act ("NDAA") that led to his veto of the annual defense policy bill last month.
Overall, the new budget deal provided the Pentagon with a two-year budget certainty. This is especially important as defense programs require long-term strategic planning and multi-year acquisition contracts. Again, the agreement gives the military a higher budget than it would have witnessed under the spending caps. This provides some respite following six consecutive years of budget austerities.
The new agreement increased the security spending limit by about $25 billion to $548 billion for fiscal 2016. It also provided $58 billion in funding for the Pentagon's separate war fund, the overseas contingency operations ("OCO") fund.
However, the total defense top line for fiscal 2016 is about $5 billion short of the original White House budget request and the Republican congressional budget resolution. Congress had earlier wanted $612 billion but settled for $607 billion as part of a budgetary agreement with the White House.
Instead of overruling the President's veto of the defense bill, Congress opted to cut $5 billion in defense spending authorized by the NDAA in line with the budget deal. The House has already passed the new bill this week and the Senate is preparing to vote next week.
Of the $5 billion defense policy bill cut, an easy $1 billion would come from estimated fuel savings while the balance will definitely hit the Pentagon hard.
Nevertheless, every fiscal year, no matter how constrained the funding picture, the Pentagon almost always gets its way. A classic example can be drawn from the recent third-quarter earnings session wherein the earnings beat ratio of all aerospace and defense companies is an impressive 77.8%. They were not only up against the ongoing budget austerity but were subject to a tepid economic growth scenario throughout the third quarter of 2015.
Growth remained challenged for most of the quarter thanks to a strong dollar and weak energy prices. Moreover, the persistent slowdown in China deepened global economic woes. In spite of the macro issues, the defense companies held up well this past quarter given the elevated geopolitical risk and strong commercial sales. They have not only reported better-than-expected results but also lifted their views in most cases.
Investors can still bet on the prime defense contractors who know how to deal with top-line budget pressure to come up with convincing bottom-line results. Below, we have listed four such stocks with encouraging prospects.
Northrop Grumman Corp.NOC
Northrop has a strong presence in the Air Force as well as Space & Cyber Security programs. Revenue and earnings growth continue to be driven by its wide presence in the current focus areas of cyber security, modernization of defense and homeland security assets, intelligence, surveillance and reconnaissance ("ISR") systems, advanced electronics and software development.
This $33.95-billion-market-cap-defense Zacks Ranked #3 (Hold) player is a major member of the Lockheed Martin led team for the F-35, the industry's costliest program.
P/E (F1): 19.03 (versus 21.5 for the industry)
Expected 3-5 yr EPS growth rate: 7.8%
Lockheed Martin Corp.LMT
Lockheed Martin is the largest U.S. defense contractor with a platform-centric focus that guarantees a steady inflow of follow-on orders from a leveraged presence in the Army, Air Force, Navy and IT programs.
A politically unstable planet will ensure that the arms merchants are not out of business. Moreover, this Zacks Ranked #3 stock has fared well in spite of U.S. defense budget cuts over the last couple of years. The prime contractor reported better-than-expected third-quarter earnings along with higher revenues, solid margins, and strong cash flows, buoyed by robust sales of its F-35 Joint Strike Fighter. The solid quarterly results have enabled it to lift its 2015 guidance for sales, operating profit, and EPS.
P/E: 19.23 (versus 21.5 for the industry)
Expected 3-5 yr EPS growth rate: 7%
Leidos Holdings, Inc.LDOS
The company provides science and technology solutions in the areas of national security, engineering and health. It sports a Zacks Rank #1 (Strong Buy) and has a market cap of $4.01 billion.
The backlog at the end of the third quarter was $10.5 billion, up 26% year over year. The company scored three big wins in July and August that will likely push shares higher. These wins will also help it to boost its top line at a time of drastic defense cuts. Thanks to the strong third quarter, the company raised its full year earnings as well as revenue guidance.
P/E: 20.42 (versus 21.5 for the industry)
Expected 3-5 yr EPS growth rate: 8%
Last but not the least on our radar is the aerospace behemoth, Boeing. With a market cap of $99.28 billion, Boeing is the largest aircraft manufacturer in the world in terms of revenues, orders and deliveries, and one of the largest aerospace and defense contractors. It has already reported stellar third-quarter numbers with higher profits (up 18% year over year) and strong cash flows (up 72%).
The company delivered 580 commercial jetliners so far this year, increasing 9.8% year over year and beating its archrival Airbus. Demand for its commercial airplanes is on the rise due to a steady improvement in passenger and freight traffic. It also lifted its 2015 EPS guidance following its third-quarter upside.
This Zacks Ranked #2 (Buy) company has a long-term earnings growth expectation of 13.5% and a forward P/E of 18.07.
Amid the ups and downs of Federal budgets, we advise investors to consider this trouble-free and proven investment strategy of putting in money where the fundamentals are strong. Despite a multitude of challenges, the long-term outlook for the defense industry has held up pretty well.
Increasing threats and the need to safeguard the interest of nations and people have pushed up demand for U.S. weapons exports, benefiting the U.S. defense manufacturers. Regional conflicts and forces of autocracy rear their ugly face up, leading to armed confrontations time and again.
The ISIS and Syrian conflict, continued saber-rattling by the North Korean leadership and high tensions over the disputed ownership of islands in the East and South China Sea are some of the ongoing global flashpoints. And above all, homeland security remains a vital issue where defense players with their evolving technology continue to play a key role.
The Zacks Industry Rank for Aerospace & Defense is #44 out of 257. This corresponds to the top one-third of the list, implying a positive outlook.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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